Armour ShareCapitalCreditor 2000

Share Capital and Creditor Protection: Efficient Rules for a Modern Company Law
Author(s): John Armour

Source: The Modern Law Review , May, 2000, Vol. 63, No. 3 (May, 2000), pp. 355-378
Published by: Wiley on behalf of the Modern Law Review
Stable URL: https://www.jstor.org/stable/1097174
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Share Capital and Creditor Protection: Efficient Rules
for a Modem Company Law
John Armour*
This article examines the case for rules of company law which regulate the raising
and maintenance of share capital by companies. The enquiry has practical
relevance because the content of company law is currently under review, and the
rules relating to share capital have been singled out for particular attention. The
existing rules, which apply generally, are commonly rationalised as a means of
protecting corporate creditors. The analysis considers whether such rules can be
understood as responses to failures in the markets for corporate credit. It suggests
that whilst the current rules are unlikely, on the whole, to be justified in terms of
efficiency, a case may be made for a framework within which companies may 'opt
in' to customised restrictions on dealings in their share capital.
Introduction
A number of provisions of the Companies Act 1985 regulate dealings with

corporate share capital.1 These are commonly thought to be unduly complex,2 and
to lack coherence.3 Some have questioned whether their existence is justified.4 Th
provisions have been identified as a 'key issue' for reform under the ongoin
Company Law Review.5 This article seeks to elucidate the function of these rule
and to investigate their role - if any - in a 'modem company law'.
A common rationalisation of the share capital provisions is that they protect
corporate creditors from the abuse of limited liability by shareholders.6 The ide
that creditors need such protection is of course used to explain a wide range of
company and insolvency law doctrines. Yet a principle of 'creditor protection' per
se tells us little about the extent to which such rules are required. By itself, it fai
to have regard to the consequences for other stakeholder groups, or the econom
more generally.
* School of Law, University of Nottingham and ESRC Centre for Business Research, University
Cambridge.
I thank Brian Cheffins, Simon Deakin, Eills Ferran, Dan Prentice, Chris Riley, Adrian Walters and two
anonymous referees for helpful comments and suggestions on earlier versions. I am also grateful for
comments received following presentations to the SPTL's Company Law Section at the annual conference
in Leeds, September 1999, and to a University of Cambridge Centre for Corporate and Commercial Law
Seminar in November 1999. The usual disclaimers apply.
1 Companies Act 1985, Parts IV, V and VIII.

2 eg L.S. Sealy, Company Law and Commercial Reality (London: Sweet & Maxwell, 1984) 8-16; J.H.
Farrar and B.M. Hannigan, Farrar's Company Law, 4th ed (London: Butterworths, 1998) 180.
3 eg Re Scandinavian Bank Group plc [1988] Ch 87, 101 per Harman J.
4 B.R. Cheffins, Company Law: Theory, Structure and Operation (Oxford: OUP, 1997) 528-533. See
generally B. Manning, Legal Capital, 2nd ed (Mineola, NY: Foundation Press, 1982).
5 Department of Trade and Industry, Modern Company Law for a Competitive Economy (London: DTI
1998) 6; Company Law Review Steering Group, The Strategic Framework (London: DTI, 1999) 19.
6 eg Company Law Review Steering Group, Company Formation and Capital Maintenance (London:
DTI, 1999) 22.
C The Modem Law Review Limited 2000 (MLR 63:3, May). Published by Blackwell Publishers,
108 Cowley Road, Oxford OX4 1JF and 350 Main Street, Malden, MA 02148, USA. 355

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The Modern Law Review [Vol. 63
Economic analysis offers a way o

offs, such as the extent to which c
mode of reasoning has become
debates, informing a number of ac
recent Consultation Paper by the
Law Review Steering Group (CLRS
a commitment to 'competitiveness
will 'maximise wealth and welfare as a whole'.9 In the wake of these
developments, the present enquiry asks what light economic analysis
on the following question: to what extent should the law relating to sha
seek to protect creditors?
The content is structured as follows. The opening section develops an ev
framework, building on the 'goals' set out in the Strategic Framework. T
applied in the next three sections, which investigate respectively: (i) how
which 'protect' creditors might - in theory - enhance efficiency; (ii) how
relating to share capital can be seen as a means of protecting creditors; a
whether the current law is in fact likely to enhance efficiency. It then co
with some general observations about the CLRSG's preliminary suggestio
reform. At the outset, it should be emphasised that the continuing evolutio
Company Law Review, along with a relatively limited academic literature
capital,10 imply that this contribution is only preliminary.
The goals of a modern company law
The starting-point for the analysis is taken from the three 'guiding princi
the reform of company law, set out in the Strategic Framework docume
first is entitled 'facilitation of transactions', and intones that a key role fo
the corporate arena is the support and enhancement of market-led contr
solutions. The Review adopts a 'presumption against prescription', suggesti
the merit of regulation must henceforth be demonstrated in terms of its '
benefits'.12 The second guiding principle is entitled 'accessibility: ease of
identification of the law'.13 Its aim is that the law should entail 'minimum
complexity and maximum accessibility.' The third principle suggests that th
allocation of responsibility for enforcement of a particular rule be chosen with
sensitivity.14
These guiding principles are presumably intended to provide a basic
methodology for the assessment of current company law and the development of
7 For an overview, see B.R. Cheffins, 'Using Theory to Study Law: A Company Law Perspective',
(1999) 58 CLJ 197, and sources cited therein.
8 The Law Commissions, Company Directors: Regulating Conflicts of Interests and Formulating a
Statement of Duties, LCCP 153, SLCDP 105 (London: TSO, 1998) Part III. See also The Law
Commissions, Company Directors: Regulating Conflicts of Interests and Formulating a Statement of
Duties, Law Com 261, Scot Law Com 173 (London: TSO, 1999) 13-31.
9 n 5 above, 8-9.
10 Outstanding exceptions include E. Ferran, Company Law and Corporate Finance (Oxford: OUP,
1999) 279-454, and in the US context, Manning, n 4 above. From an economic perspective, see G.P.
Miller, 'Das Kapital: Solvency Regulation of the American Business Enterprise', University of
Chicago Working Paper in Law & Economics (2d) No 32, April 1995; Cheffins, n 4 above, 521-537.
11 n 5 above, 15-17.
12 ibid 16.
13 ibid.
14 ibid 17. The third principle is accorded considerably less detailed treatment than the first two.
356 0 The Modem Law Review Limited 2000

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May 2000] Share Capital and Creditor Protection
reforms. The first principle seems to be the most funda

the justification of the very existence of legal rules, wh
concerned with their form. The Strategic Framework d
the 'presumption against prescription' may be rebutted
[M]arkets and informal pressures combined with transparency
this may happen because the participants lack the market
contract effectively.15
It would seem that an analysis of the (dys)functioning o

the ways in which state intervention through the corp
enhance them. A rebuttal of the presumption necess
market transactions in some way be inadequate, and th
their failings. If and only if such analysis demonstrate
second and third guiding principles come into play: the
should be as simple as is possible to achieve their stated objective, and
responsibility for their enforcement should be allocated accordingly.
The first guiding principle begs a further question: on what basis is the 'adequacy'
of a market to be measured? A standard technique employed by economists is to
compare the system under consideration with an environment of 'perfect
competition'. In the context of corporate creditors, we might begin by imagining a
world of perfect capital markets, in which inter alia all parties have perfect
information and financial contracting is costless.16 Under these conditions, creditors
need no legal protection, because their contracts will provide them with interest rate
returns perfectly correlated to the risks that they bear. Moreover, shareholders could
never benefit at creditors' expense by undercapitalising a company.
A world of perfect capital markets is of course not the real world.17 Yet as a
thought-experiment it is a means of identifying the weaknesses of real markets for
corporate credit. Such weaknesses may lead to wealth being transferred from
creditors to shareholders. This in turn may justify legal rules which 'protect'
creditors. The justification may be noninstrumental, for example if such
expropriation is thought to violate norms of fairness. Alternatively, it might be
instrumental, grounded on a claim that these wealth transfers mean that markets
fail - as perfect markets would not - to allocate resources to those who value them
most highly: in other words, that they are (allocatively) inefficient.is For example,
the possibility of expropriation may deter creditors from investing in sound
business projects, and distort firms' selection of projects away from those which
create wealth in favour of those which merely transfer wealth. Legal rules which
restrict such transfers may thereby be justifiable on the basis that they enhance
efficiency. In light of the Strategic Framework's emphasis on 'efficiency', the
current analysis focuses on this latter justification.
A critic might assert that simply to diagnose that markets do not meet a
hypothetical standard of perfection is insufficient to justify prescribing legal
15 ibid.
16 F. Modigliani and M. Miller, 'The Cost of Capital, Corporation Finance and the Theory of
Investment' (1958) 48 American Economic Review 261. See A. Barnea et al, Agency Problems and
Financial Contracting (Englewood Cliffs, NJ: Prentice-Hall, 1985) 6-24; W.L. Megginson,
Corporate Finance Theory (Reading, MA: Addison-Wesley, 1997) 316-323; R.A. Brealey and S.C.
Myers, Principles of Corporate Finance (New York, NY: McGraw-Hill, 6th ed, 2000) 473-484.
17 A leading corporate finance textbook warns students that they may find the perfect capital market
assumptions 'almost laughably unrealistic' when they first encounter them (Megginson, ibid 316).
18 On the different meanings of 'efficiency', see S. Deakin and A. Hughes, 'Economic Efficiency and
the Proceduralisation of Company Law' (1999) 3 CfiLR 169, 173-175.
C The Modem Law Review Limited 2000 357

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intervention as the remedy. Such a cr

a real market, with the addition of
market left to its own devices.19 The CLRSG's reference to the 'costs and benefits'
of legal rules may be read as being attuned to such a critic, and implying that a
comparison of aggregate social wealth must be drawn between 'a world with legal
rule x' and 'a world without it'.20
No claim is made here that efficiency should be the sole or even the major goal
of company law,21 or indeed that the CLRSG necessarily subscribe to either of
these views. As the Company Law Review progresses, some fundamental
questions about the extent to which company law should seek to further
noninstrumental goals must be answered.22 Yet unless - contrary to the way in
which the Strategic Framework is written - the answers suggest that efficiency has
no normative role to play, it is still important to analyse company law in terms of
its ability to achieve that goal.
How might law assist in facilitating transactions with corporate

creditors?
The first step in the analysis considers factors which detract from the perfection of
real markets for corporate credit, and asks - at a fairly high level of abstraction -
whether rules of company law which 'protect' creditors might be able to ameliorate
them.
Market power
Where one party has market power, the other has limited freedom in contracting.23
This is likely to give rise to inefficiencies in the terms of trade - for example, a
monopolist will tend to under-produce. Some creditors may enjoy a degree of
market power - for example, banks are commonly alleged to be in such a position
vis-a-vis small firms. However, in other cases, a firm enjoys market power as
against some of its creditors, as with trade suppliers who rely on a firm for a large
proportion of their business. And in many cases, there will be no market power
either way. Hence it seems unlikely that general rules of company law - as
opposed to competition law, for example - would be an appropriate means of
regulating market power.
19 See eg G.J. Stigler, The Citizen and the State: Essays on Regulation (Chicago: University of Chicago
Press, 1975) 103-113; see also A.I. Ogus, Regulation: Legal Form and Economic Theory (Oxford:
Clarendon Press, 1994) 30. Stigler's argument goes further, demanding that it also be shown that the
rules to be compared are those which a real political process is capable of implementing (ibid 114-
141). The problems raised by 'public choice' theory are, however, beyond the scope of the current
analysis, and the assumption is made throughout that it is possible to craft legislation in the public
interest.
20 ie a version of the 'Kaldor-Hicks' efficiency criterion. See J. Coleman, 'Efficiency, Utility, and
Wealth Maximization' (1980) 8 Hofstra LR 509, 512-520.
21 See S. Deakin and A. Hughes, 'Economics and Company Law Reform: A Fruitful Partnership?'
(1999) 20 Co Law 212.
22 See eg The Strategic Framework, n 5 above, 49-51.
23 ibid 15.
358 ( The Modem Law Review Limited 2000

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Precontractual information asymmetries

One pervasive imperfection of real credit markets is th
distribution of information. This can give a party wi
opportunity to redistribute wealth from a less-informe
it is costless to acquire information about borrowe
creditors who remain 'rationally ignorant' of relevant
will under-price some loans, but we would expect the c
to other borrowers through pricing according to avera
this may make the rate seem unattractively high to bo
prospects.24 An 'adverse selection' effect will be genera
borrowers decide not to enter the market for loans. Th
will be those with poor financial prospects.
These problems may be mitigated by market-ba
'signalling'. A signal is something which a high-qualit
is costly for a low-quality party.25 Hence signalling be
information to uninformed parties. Borrowers with go
an incentive to signal this where the costs of signalling
in price which they can secure as a result.
Legal rules may also have a role to play: the la
misrepresentation is one instance. An example relevant
loans is the mandatory disclosure of financial informa
by an independent third party.26 This will tend to lo
information about potential borrowers, thus reducing
'rationally ignorant' creditors. Whether or not rule
efficient is a different question, however. For this to b
that the social savings in information costs are gre
compliance with the provisions.27
Incomplete contracts and postcontractual opp

Economists use the notion of a 'complete' contract to
every possible contingency relevant to the perform
specifies what parties must do under each circumstan
joint returns.28 Real contracts are incomplete
contingencies is costly - not only the costs of writin
quantifying the probability of the contingency's occu
appropriate actions. Beyond a certain point the costs o
expected benefits. Similarly, where one party is b
24 G. Akerlof, 'The Market for Lemons: Quality Uncertainty and

Quarterly Journal of Economics 488; See generally C. Wilson, 'Ad
(eds), Allocation, Information, and Markets (London: Macmillan,
25 See A. Schwartz, 'Security Interests and Bankruptcy Priorities: A
10 J Leg Stud 1, 14-15; G.G. Triantis, 'Secured Debt Under Cond
(1992) 21 J Leg Stud 225, 250. See generally A.M. Spence, Market
in Hiring and Related Screening Processes (Cambridge, MA: Harv
26 Cheffins, n 4 above, 512-521.
27 ibid (taking a sceptical view of the likely efficiency of disclosu
Game Theory and the Law (Cambridge, MA: Harvard University
28 0. Hart, Firms, Contracts, and Financial Structure (Oxford: C
Kaplow and S. Shavell, 'Economic Analysis of Law' NBER Work
27-28.

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circumstances relevant to his perf

observe what has happened or been
party such as a court, it may not
depend on that information.29 Co
information asymmetries can be e
actions which favour him and imp
In the context of corporate credi
likely to know more than creditor
their business. There are also a nu
engage which will enhance the
creditors.30 A classic example is
wealth transfers may be effected
price loans accurately on the ba
projects, then shareholders may
switching to higher-risk project
increases what shareholders can
because of limited liability - does
Conversely, its only effect on cred
project fails.
This analysis assumes that corporate managers act in the interests of
shareholders. This is obviously true for owner-managed businesses. In public
firms, managers' private interests are likely to diverge from those of shareholders,
with the latter in the first instance bearing the costs generated by managerial self-
serving behaviour. Paradoxically, however, the better the incentive mechanisms -
executive option schemes, threats of hostile takeovers, and the like - for resolving
this 'problem' and ensuring that managers act in shareholders' interests, the
stronger will be the managers' incentives to transfer wealth to shareholders from
creditors.32
These sorts of activity may result in net social losses, even if we assume that
both creditors and shareholders are able to diversify or insure so as to be risk-
neutral. First, debtors' investment decisions may be skewed: they may choose
projects on the basis of their potential for transferring wealth from creditors, rather
than their potential to generate new wealth. Second, the supply of credit may
become restricted. As the creditors' perceived risks increase, the necessary risk
premium required to compensate them in advance rises sharply. Lenders would
start to ration credit beyond a certain level of risk,33 with less aggregate credit
being offered in the market for corporate loans. If companies have restricted access
to equity finance, then this would lead to a social cost: good business projects
would go unfunded.
29 A. Schwartz, 'Relational Contracts in the Courts: An Analysis of Incomplete Contracts and Judicial
Strategies' (1992) 21 J Leg Stud 271; A. Schwartz, 'Incomplete Contracts' in P. Newman (ed) The
New Palgrave Dictionary of Economics and the Law (Basingstoke: Macmillan, 1998) 277.
30 M.C. Jensen and W.H. Meckling, 'Theory of the Firm: Managerial Behaviour, Agency Costs and
Ownership Structure' (1976) 3 Journal of Financial Economics 305, 333-343; S.C. Myers,
'Determinants of Corporate Borrowing' (1977) 5 Journal of Financial Economics 147; C.W. Smith
and J.B. Warner, 'On Financial Contracting: An Analysis of Bond Covenants' (1979) 7 Journal of
Financial Economics 117; Barnea et al, n 16 above, 33-38.
31 eg text to notes 89-91 and n 102, below.
32 eg 'Share and Share Unalike' The Economist, 7 August 1999.
33 One reason is that under the Insolvency Act 1986 s 244, 'extortionate' credit transactions are
unenforceable in the borrower's insolvency.
360 C The Modern Law Review Limited 2000

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It is therefore rational for parties to spend mon

prohibitions on wealth-reducing activities, coupled with
to observe the borrower's actions.34 As well as the all-
duration and repayment, lenders in fact frequently c
which impose restraints on the borrower's investm
Economists suggest that these can be explained as the p
the costs of lender-borrower conflicts of interest,35
'financial agency costs'.36 This is supported by studie
prevalence and restrictiveness of loan covenants increa
debt to equity ('gearing'), a factor which would intens
to expropriate creditors.37
The ability of parties to neutralise financial agency co
in part on information costs - how easy it is for the cr
actions and to verify instances of opportunism to the cour
of contractual specification. Given these difficulties, t
prohibitions will be under-inclusive, but also that the
inclusive, in which case they will need to be renegoti
exacerbated by 'free-riding' amongst creditors. Be
'parallel', the debtor's freedom of action is determine
covenant to which it is subject and which is enforced.
free-ride on each others' investments in contracting, m
with the result that they each invest less than would
Whilst small firms may be able to reduce this problem
of their external finance with a single creditor such as
'cross-default' clauses - defining 'default' to include a
covenant - suggests that creditors of larger firms do in
this way.40
In theory, statutory rules might assist parties i
contractual specification, by acting as 'terms' supplied
state's investment in term design could be spread ove
capturing economies of scale and generating better-sp
could justify writing for stand-alone contracting. It migh
creditors' free-rider problem as it affects investment
corollary of this, emphasised in the law and economics
supplied rules should generally be defaults - ie onl
specify otherwise - rather than mandatory, so parties
34 Jensen and Meckling, n 30 above, 334-343.

35 eg Smith and Warner, n 30 above.
36 eg G.G. Triantis, 'A Free-Cash-Flow Theory of Secured Debt and
LR 2155, 2158.
37 On UK practices, see D.B. Citron, 'Financial Ratio Covenants
Accounting Policy Choice' (1992) 22 Accounting & Business Resea
Taylor, 'Evidence on the Practice of UK Bankers in Contracting fo
394, 397. On US practices, see eg J.C. Duke and H.G. Hunt III, 'A
Covenant Restrictions and Accounting-Related Debt Proxies' (199
Economics 45; E.G. Press and J.B. Weintrop, 'Accounting-Based C
Debt Agreements' (1990) 12 Journal of Accounting and Economi
38 Saul Levmore, 'Monitors and Freeriders in Commercial and Cor
49, 53-54; M. Kahan, 'The Qualified Case Against Mandatory Term
565, 596-598.
39 see J. Armour and S. Frisby, 'Rethinking Receivership', forthcoming.
40 J.F.S. Day and P.J. Taylor, 'Loan Contracting by UK Corporate Borrowers' [1996] JIBL 318, 323;
P.R. Wood, 'Term Loan Agreements: A Guide to Basics, Part 3' (1996) 1(8) Com Law 51, 52.
? The Modem Law Review Limited 2000 361

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do not find themselves saddled wit

applied to corporate law by Easter
function is to supply 'off the rack
Collective action problems a

'Collective action' problems arise w
inconsistent with their interests a
which 'protect' creditors, not fro
creditors face some collective actio
whilst the debtor firm is solvent,4
becomes insolvent. The structure
creditors of an insolvent firm int
inefficient incentives to engage in
debtor's business even where this is
of collective transformation of
insolvency, so as to ameliorate the
scope for variation in the way in w
A related problem is so-called 'ho
reference to the renegotiation of l
the interests of the creditors as a
contract with the firm, unanimou
demand a payment, greater tha
renegotiation, simply as the price
significant obstacles to efficient re
by the state of some form of c
majority of creditors can bind a m
'Creditors' who do not contract
A rather different set of issues is raised by so-called 'involuntary' creditors

The basic problem is by now well known, having been frequently discussed in
the literature related to limited liability.48 Consensual creditors are - in theory
at least - able to decide whether or not to lend, and if so how much, and on
what terms. Nonconsensual claimants, such as tort victims, the Environment
41 eg I. Ayres and R. Gertner, 'Filling Gaps in Incomplete Contracts: An Economic Theory of Default
Rules' (1989) 99 Yale LJ 87, 87-89.
42 F.H. Easterbrook and Daniel R. Fischel, The Economic Structure of Corporate Law (Boston, MA:
Harvard University Press, 1991) 14-15.
43 Text to notes 38-40 above.
44 T.H. Jackson, 'Bankruptcy, Non-Bankruptcy Entitlements, and the Creditors' Bargain' (198
Yale LJ 857.
45 One technique is for the state to impose a collective liquidation procedure. However, the use of
security interests can also resolve the prisoner's dilemma, by establishing in advance who will get
what (R.C. Picker, 'Security Interests, Misbehaviour, and Common Pools' (1992) 59 U Chic LR 645).
46 M.J. Roe, 'The Voting Prohibition in Bond Workouts' (1987) 97 Yale LJ 232, 238.
47 eg Companies Act 1985, ss 425-427; Insolvency Act 1986, Part I.
48 eg P. Halpern et al, 'An Economic Analysis of Limited Liability in Corporation Law' (1980) 30 U
Toronto LJ 117, 144-147; n 42 above, 49-55; H.B. Hansmann and R. Kraakman, 'Towards Unlimited
Shareholder Liability for Corporate Torts' (1991) 100 Yale LJ 1879; D. Leebron, 'Limited Liability,
Tort Victims, and Creditors' (1991) 91 Colum LR 1565; B. Pettet, 'Limited Liability - A Principle for
the 21st Century?' (1995) 48 CLP 125, 152-157; Cheffins, n 4 above, 506; D. Goddard, 'Corporate
Personality: Limited Recourse and its Limits' in R. Grantham and C. Ricketts (eds.), Corporate
Personality in the Twentieth Century (Oxford: Hart Publishing, 1998) 11, 32-40.
362 C The Modem Law Review Limited 2000

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Agency and the Inland Revenue, are not. The idea i

are unable to adjust the terms on which credit is exte
able to profit at their expense by, for example, under
subsidiaries.
The implications for efficiency depend not on the involuntary nature of the
obligation, but on the economic rationale behind imposing it on the firm. One such
basis is the control of externalities. At its simplest, the idea of an 'externality'
encompasses any welfare effect felt by one party as a result of another actor's
production or consumption decisions that is not mediated via the price system.49
Economic actors can be encouraged by the state to 'internalise' the social cost by
awarding liability claims to those affected by their activities.50 However, th
incentives are dulled where a firm's assets are worth less than the expected value
of an obligation which might be imposed upon it by tort or environmental law, and
its managers will maximise shareholder value by reducing expenditure on
precaution against causing harm.51 Limited liability readily facilitates such
'judgment proofing': each hazardous activity can be carried on by a separate
company, with limited assets, and the costs of any harm it generates thereby
insulated from all other assets. It may be that general rules designed to prevent
such 'judgment proofing' and thereby protect 'involuntary' creditors might
enhance efficiency.
How does the law relating to share capital protect creditors?
We now turn to an examination of the rules which restrict dealings in corporate

share capital. Whilst some of the provisions have at times been rationalised a
protecting the interests of shareholders,52 or even the general public,53 the curren
analysis follows the CLRSG in focusing on their role as mechanisms of 'creditor
protection'.54 It should be emphasised that the operation of these rules does not
depend on the debtor firm being insolvent, and that the protection they offer is in
addition to a battery of other mechanisms that swing into operation at or near the
latter's insolvency.55
In this section, we will examine the rules broken down into the following four
categories: (i) raising capital; (ii) minimum capital requirements; (iii) capita
maintenance; and (iv) financial assistance. As a preliminary matter, it is useful to
observe that the statutory provisions as a whole form two tiers of regulation.56 At a
basic level are rules which are applicable to all companies, and which originate in
nineteenth-century case law. Superimposed on these is a set of more restrictive
49 eg J.-J. Laffont, 'Externalities' in Eatwell et al (eds), n 24 above, 112.

50 Other techniques include direct regulation and taxation according to social cost. See R. Coase, 'Th
Problem of Social Cost' (1960) 3 JL & Econ 1, 1; Kaplow and Shavell, n 28 above, 21-24.
51 Hansmann and Kraakman, n 48 above, 1882-1884.
52 eg Preamble to the Second Council Directive of 13 December 1976 (77/91/EEC) [1977] OJ L26/1.
53 eg The Purchase By a Company of its Own Shares - A Consultative Document, Cmnd 7944 (HMSO
London, 1980) paras 5, 16 (rules restricting share repurchases protect 'market integrity'). See also n
99 below.
54 The Strategic Framework, n 5 above, 81; Company Formation and Capital Maintenance, n 6 above,
22.
55 eg (i) directors' fiduciary duties to creditors (see eg, West Mercia Safetywear Ltd v Dodd [1988]
BCLC 250, 252); (ii) wrongful trading (Insolvency Act 1986, s 214); (iii) creditors' ability to
commence collective insolvency proceedings (ibid ss 8(1)(a) 122(1)(f)); and (iv) provisions allowing
a liquidator or administrator to 'unwind' certain transactions (ibid ss 238-245).
56 n 1 above.

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provisions derived from the Secon

tier of rules applies only to public
untouched in respect of private com
Raising capital
A number of provisions apply to t
through an issue of shares. The bas
100 of the Companies Act 1985, is
their par value.58 The 'par value' is
share. It need bear no resemblance to their market value. An issue of shares is
recorded in a company's accounts by entering a figure of 'issued capital' equal to
the number of shares, multiplied by their par value. Any amount by which the issue
price exceeds par must be entered as 'share premium'.59 Together, these are
represented on the 'right hand side' of the corporate balance sheet, as part of the
shareholders' funds.60
Paradoxically in the light of the insistence on the minimum issue price, if shares
in private companies are allotted for non-cash consideration, then no serious
attempt is made to ensure that the assets supplied are in fact worth the par value of
the shares.61 In the case of public companies, the value of non-cash consideration
must be subjected to an independent expert's valuation.62 However, there is no
requirement that shares in any company be issued at their full market price, where
this is greater than par.63
These rules provide creditors with information about the value of the assets
contributed by the shareholders to the company - which might be relevant to
lending decisions - and seek to guarantee that this information is truthful.64 Would-
be creditors may view a company's public documents and be misled if assets
representing the share capital were never actually contributed to the company.
Considerations of this sort are apparent in the reasoning of the House of Lords in
Ooregum (Gold Mines of India) Ltd v Roper.65 As Lord Halsbury stated, in laying
down the rule that a company may not allot shares for less than par, '[t]he capital is
fixed and certain, and every creditor of the company is entitled to look to that
capital as his security'.66
In economic terms, these rules might be understood as a response to problems of
information asymmetry in corporate credit markets. They publicise to investors the
value of the assets that shareholders put into the company, and seek to ensure that
57 n 52 above, implemented by the Companies Act 1980 and now consolidated into the Companies Act
1985. See generally D.D. Prentice, The Companies Act 1980 (London: Butterworths, 1980).
58 Ooregum (Gold Mines of India) Ltd v Roper [1892] AC 125.
59 Companies Act 1985, s 130.
60 ibid Sch 4. See generally Ferran, n 10 above, 44-48.
61 Re Wragg [1897] 1 Ch 796 is the locus classicus of the doctrine that, 'The value paid to the company
is measured by the price at which the company agrees to buy what it thinks it worth its while to
acquire.' (ibid 831, per Lindley LJ). It does not apply where the transaction is a sham or colourable
(ibid 830) or where it is clear from the terms of the contract that the consideration bears no
resemblance to the par value of the shares (Hong Kong Gas Company v Glen [1914] 1 Ch 527).
62 Companies Act 1985, ss 103, 108. The regime also prohibits outright the giving of services as
consideration (s 99(2)) or arrangements which may take more than five years to perform (s 102)).
63 Hilder v Dexter [1902] AC 474. That said, issuing shares below market value may constitute a breach
of directors' duties (see Shearer v Bercain Ltd [1980] 3 All ER 295, 307).
64 See Ferran, n 10 above, 283.
65 n 58 above.
66 ibid 133. See also ibid 137 per Lord Watson, 140-141, per Lord Herschell.

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this information is truthful. Two observations should be made about this rationale.
First, this mechanism can obviously only assist consensual creditors. Second, the
rationale suffers from an internal weakness: the ease with which the rules may be
side-stepped by private companies through the use of non-cash consideration.
However, the 'expert valuation' rules introduced to comply with the Second
Directive can be seen as a means of plugging this gap, at least in relation to public
companies.
Minimum capital
The rules relating to minimum capital apply only to public companies. They
stipulate that such a company may not commence trading unless it has an allotted
capital of at least ?50,000.67 Furthermore, if such a company's net assets fall below
one-half of its called-up share capital, then the company is required to convene a
shareholders' meeting 'for the purposes of considering whether any, and if so what,
steps should be taken to deal with the situation'.68
These rules can be understood as a system of creditor protection when viewed in
conjunction with the 'expert valuation' rules regarding the raising of capital.
Together, they seek to ensure that at least a minimum level of assets is contributed
to a (public) company by its shareholders, and that if for some reason the
company's net worth should subsequently fall below a 'threshold level', then steps
should be taken to remedy the situation.69 Such a regime can act to protect
creditors without their even being aware of its existence. Because of this, it might
be seen as a means of protecting so-called 'involuntary' creditors.70
Capital maintenance
The Oxford English Dictionary defines the verb 'to maintain' as, 'to keep up,
preserve, cause to continue in being ... to keep vigorous, effective or unimpaired, to
guard from loss or derogation'.71 In accordance with this definition, we might expect
the doctrine of capital maintenance to require the preservation intact of the value of
the shareholders' contribution of assets to a company - ie a rule requiring the
'maintenance' of some net asset value. As we have seen, the minimum capital rules
for public companies go some way towards this. Yet the classical capital maintenance
doctrine, as developed by the courts and now reflected in the Companies Act 1985,
does nothing of the kind.72 It directs merely that capital must not be returned to
shareholders. 'Capital' in this sense refers not to the assets of the company - the left
hand side of the balance sheet - but to the right hand side. An ordinary shareholder
has rights: (i) to such dividends as the directors from time to time declare (whilst the
company is a going concern), and (ii) should the company be wound up, to a pro rata
67 Companies Act 1985, ss 11, 118. Only one-quarter of this need actually be paid-up (ibid s 101(1)).
See E. Ferran, 'Creditors' Interests and 'Core' Company Law' (1999) 20 Co Law 314, 317.
68 Companies Act 1985, s 142.
69 cf Ferran, n 67 above.
70 See Case 212/97 Centros Ltd v Erhvervs-og Selskabsstyrelsen [1999] 2 CMLR 551, 586-587, in
which the Danish government sought to justify their country's minimum capital laws on the basis,
inter alia, that they protected involuntary claimants.
71 Oxford English Dictionary, 2nd ed (Oxford: Clarendon Press, 1989) Vol IX, 223.
72 On the doctrine's history, see B.S. Yamey, 'Aspects of the Law Relating to Company Dividends'
(1941) 4 MLR 273; E.A. French, 'The Evolution of the Dividend Law of England' in W.T. Baxter and
S. Davidson, Studies in Accounting, 3rd ed (London: ICAEW, 1977) 306. For practical purposes, the
common law principle has been surpassed by the statutory rules introduced in 1980.
C The Modern Law Review Limited 2000 365

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share of capital and surplus, insofar

therefore possible to think of capit
company, which is payable only in win
company's creditors.74 The capital
remains that way.
The key statutory provision embod
of the Companies Act 1985. This pr
assets to shareholders except where th
profits available for distribution. Di
cumulated net realised profits,75 m
capital.76 The definition of 'distribu
redemption or repurchase of shares
transactions whereby assets are direct
less than market value.78 As profit
capital - which for these purpos
redemption reserve,79 this means that
The capital maintenance rules allow
impose on companies. A company m
fresh issue of shares, or by capital
Capital may be decreased, in respon
by reducing the nominal value of sh
section 135 of the Companies Act
because it does not involve any dir
creditors do not usually have any ri
Alternatively, the capital mainten
One route by which this may be do
section 135 of the Companies Act
ensure that creditors' interests are
73 see Re Northern Engineering Ltd [1994]

74 Insolvency Act 1986, s 74(2)(f); Soden v B
Ferran, n 67 above, 318.
75 On which profits count as 'realised', s
Disclosure of Distributable Profits in the
(1982) 93 No 1070 Accountancy 122; R. Lew
ed. (London: Pitman, 1996) 66-69; ICAEW
Profits and Distributable Profits Under
www.icaew.co.uk/depts/com/aug99/3 1 aug99
76 A public company must also show that it
cumulated net unrealised profits by at leas
264).
77 See ibid s 263(2)(b). These are permitted, but only in such a way that they do not reduce share capital:
they must be funded by distributable profits (s 160(1)) and because they involve a cancellation of
shares (s 160(4)) an equivalent amount must be accredited to a 'capital redemption reserve' and
subsequently treated as capital (s 170).
78 Re Halt Garage (1964) Ltd [1982] 3 All ER 1016; Aveling Barford Ltd v Perion Ltd (1989) 5 BCC
677; Barclays Bank plc v British & Commonwealth Holdings plc [1995] BCC 19.
79 ibid ss 130(3) 170(4).
80 R. Mathias, 'The Myth of Maintenance of Capital' (1995) 116 No 1228 Accountancy 92.
81 Companies Act 1985, s 263(2)(a); Table A art 110. Bonus shares may also be funded from share
premium or capital redemption reserve (ss 130(2) 170(4)) but this only recycles capital from one
account to another.
82 ibid s 136(2); Re Meux' Brewery [1919] 1 Ch 28. If the loss might only be temporary, the court may
require the company to promise to create a capital reserve account if it is recovered (Re Jupiter House
Investments Ltd [1985] 1 WLR 975; Re Grosvenor Press plc [1985] 1 WLR 980).
83 Companies Act 1985, ss 136-137.
366 c The Modem Law Review Limited 2000

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company providing the court with evidence of a bank guara

debts.84 The principle may also be bypassed by private
repurchase of shares out of capital.85 Finally, any company
schemes of arrangement or company voluntary arrangemen
allow for general renegotiations of creditors' rights.86
The capital maintenance principle was clearly viewed by the
judges who developed it as a means of protecting corporate
'extra' risks associated with limited shareholder liabilit
judgment, Jessel M.R., put the matter in the following way,
The creditor, therefore, I may say, gives credit to th[e] capital, give
on the faith of the representation that the capital shall be applied only
business, and he therefore has a right to say that the corporation sha
return it to the shareholders.87
This envisages protecting creditors from the risk that

subsequently withdraw their capital investment. Conversely, the
would be lost in ordinary business activities was one which the cr
It is therefore possible to understand the capital maintenanc
of reducing the costs of postcontractual opportunism b
Distributions to shareholders reduce a company's net ass
exposed to the risk of default. Creditors' interests can b
company does not actually become insolvent.90 If lenders' loa
basis of the pre-existing levels of net assets, then this will
value of their claims,91 whilst commensurately enhancing t
shareholders' private wealth and their stake in the firm. Wh
such a distribution, assets are withdrawn from valuable pro
firm, this will result in a net social loss, as well as a redistrib
It might be thought that a straightforward solution to th
simply be to ban all asset transfers to shareholders. How
circumstances in which such transfers are efficient. Where a
and no good projects in which to invest, it is efficient for the m
to shareholders for investment elsewhere, rather than
underperforming project.92 Hence an efficient restriction wo
not all such payments. The difficulty, of course, lies in
inefficient transfers will be prohibited.
One technique is to use a conditional restriction. In other
firm is able to meet a certain minimum financial condition, s
84 The statute prescribes a lengthy procedure whereby creditors must be

reduction and either consent to it or be paid off (ibid s 136). However the co
satisfied that the 'special circumstances of the case' demonstrate cred
s 136(6)). To avoid the expense of the full procedure, it is usual to satisfy
bank guarantee of all outstanding debts (A.J. Boyle et al (eds), Gore-Brow
(Bristol: Jordans, 1986) supp 31 (1999) 13.012).
86 n 47 above.
87 Re Exchange Banking Company, Flitcroft's Case (1882) 21 ChD 518, 533-534.
88 Trevor v Whitworth (1887) 12 App Cas 409, 423-424 per Lord Watson.
89 Miller, n 10 above, 5; Cheffins, n 4 above, 521-524.
90 Other legal provisions protect creditors if the transfer renders the company insolvent (n 55 abov
91 This will be their face value, discounted for the time value of money and the risk of default. Eve
the debtor does not become insolvent, creditors are prejudiced if the risk of default increases abo
that at which they priced it, and if they wished to realise the value of the loan before maturity, as wit
bonds, secondary markets for syndicated loans, factoring of book debts, etc.
92 eg Megginson, n 16 above, 377-380.

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make payments to themselves. The

the degree of risk borne by the cre
lending what the minimum is, th
creditors have fixed 'upside' returns
firm exceeds the minimum. How
condition falls below it. Their inte
which binds only in the latter circu
financial condition will depend on a
lenders to incorporate excessive ris
expensive. Too high, and it may
unnecessarily.
The maintenance of capital doctrin
restriction of this sort. Rather than
firm for a restriction, the statuto
collective 'creditor term' into the c
determined by the size of a compa
which the shareholders are able to a
explain a number of their features
shareholders are restricted, rather tha
the doctrine does not restrict gratu
shareholders.93 It is the shareholder
depleted (or conceivably, enhance
distributions are allowed if the condit
Fourth, it explains the existence an
Where capital is paid out to shareholde
prospectively changes the terms on
changing circumstances. Note, howe
the capital maintenance rules suggests
creditors. Because the maintenance
which the restriction on distributio
creditors when coupled with a minim
Financial assistance
Sections 151-152 of the Companies Act 1985 impose very broad prohibitions on
the giving by companies of financial assistance for the purpose of an acquisition o
their shares. The original rationale for the introduction of these provisions, as
proposed by the Greene Committee, was the prevention of 'asset-stripping
takeovers.94 They had in mind transactions whereby a purchaser would borrow
heavily to buy a majority holding of a 'target' company's shares for cash, and th
rapidly sell the latter's assets, using the proceeds to discharge the loan. This can
seen as an indirect return of capital, whereby the 'old' shareholders are cashed ou
at the expense of the creditors. Hence the provisions are commonly treated as pa
of the capital maintenance regime.95
However, the ambit of the financial assistance provisions is broader than
necessary to ensure capital is not returned to shareholders. The basic prohibition
apply to any assistance which depletes the company's net assets, regardless
93 cf Barclays Bank plc v British & Commonwealth Holdings plc [1995] BCC 19, 29-31 per Harman J
94 Report of the Company Law Amendment Committee, Cmd 2657 (London: HMSO, 1926) para 30.
95 eg The Strategic Framework, n 5 above, 86; n 6 above, 39.

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whether it has distributable profits,96 and even to some tran

- which may not deplete its assets at all.97 Interestingly, the
reporting in 1962, felt that the link between capital mainten
assistance prohibitions was tenuous.98 Whilst rationales can
prohibitions which do not turn on the protection of credit
Committee saw the 'problem' of the debt-laden acquiror as n
for creditors over and above that given by the capital maint
We might today refer to a debt-laden acquisition as a
(LBO).101 There are a variety of ways in which a LBO pu
target's assets and credit rating to assist in financing such a
asset transfers of the sort that would fall foul of the capita
just a part. What is more, all of these have the potential to e
from the target's 'old' creditors. Consider a loan to the debt-
is a classic example of asset substitution - replacing one asse
Alternatively, the target could be procured to borrow heavily
proceeds to the acquiror - or similarly to guarantee the acq
case, diluting the value of the target's 'old' debt claims.102
cover each of these transactions. Coupled with the Jenkins
this suggests that the desire to protect creditors from 'LBO
explanation for the financial assistance restrictions.
This account begs one important question. Firms which
LBOs are also capable of engaging in similar types of we
should these far-reaching restrictions be imposed only
acquisition of shares? By way of a partial answer, note that
greatest incentive to behave opportunistically in a L
shareholders, but the purchasers. The legal 'purchaser'
corporate vehicle for a fairly concentrated group of own
congruence between managers' and shareholders' interests i
with high gearing, will mean that it faces unusually sev
costs.104 Probably for this reason, lenders to such ventu
stringent covenants and a well-developed business plan.105
who find themselves suddenly exposed to a firm whose c
greater incentives to gamble with their money than the
unlikely to have the benefit of such stringent covenants. Ind
corporate laws do not contain financial assistance prohib
96 Companies Act 1985, ss 152(1)(a)(iv) 152(2). See Ferran, n 67 above, 31

97 ibid s 152(1)(a)(iii). The value of a loan depends on the borrower's creditw
of any security. See Ferran, n 10 above, 373-374.
98 Report of the Company Law Committee, Cmnd 1749 (HMSO, London: 1
99 eg protecting market integrity by preventing companies engaging in 'pric
shares, and protecting minority shareholders from 'asset-stripping' where t
a majority holding. Arguably, other regulatory developments now perform
these rationales are no longer compelling (see Ferran, n 67 above).
100 n 98 above.
101 In the UK, it is more common to speak of a management buyout (MBO). However, the term 'LB
used to emphasise a transaction principally financed by debt.
102 See A. Schwartz, 'A Theory of Loan Priorities' (1989) 18 J Leg Stud 209, 228-234.
103 Brealey and Myers, n 16 above, 982; M. Wright et al, 'Venture Capitalists, Buy-outs and Corpo
Governance' in K. Keasey et al, Corporate Governance: Economic, Management and Financ
Issues (Oxford: OUP, 1997) 147, 152-153.
104 Text to n 37 above.
105 See D. Citron et al, 'Loan Covenants and Relationship Banking in MBOs' (1997) 27 Accounting
Business Research 277.
C The Modern Law Review Limited 2000 369

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number of well-documented cases in

values of their securities had bee
massive increase in gearing brough
This account of the financial assis
by reference to the so-called 'white
company is private.107 This require
assets or, to the extent that it does, t
directors must also give a statuto
solvent for 12 months.109 Superfici
in keeping with the 'LBO risk' ratio
companies, where the shares are br
up' in ownership concentration - a
However, this neglects the point th
on concentrating ownership, it will
target to a private company. Thus t
risk' offered to creditors of all fir
'whitewash' procedure.
Does the 'protection' offered
We have surveyed a number of poss

of the law relating to share capital,
for corporate credit which legal ru
whether the existence of these rule
Raising capital and informatio

For the regulation of allotments of
such rules generate - as compared
greater than the concomitant co
Historically, if a company's share p
to raise equity finance. This might
funds was required to save a financ
now be dealt with by splitting sh
provided that the total share capita
likely to generate more significant
valuers each time an issue of shares is made.
The benefit of these rules will be felt in the increased informational efficiency of
markets for corporate credit, the extent of which depends in no small way on how
useful the information is to investors. A number of empirical studies have
investigated the information taken into account by sophisticated parties in making
106 M. McDaniel, 'Bondholders and Corporate Governance' (1986) 41 Bus Law 413, 442-450; K. Lehn
and A. Poulsen, 'Contractual Resolution of Bondholder-Stockholder Conflicts in Leveraged Buyouts'
(1991) 34 J L & Econ 645, 654-657. See also Metropolitan Life Ins Co v RJR Nabisco Inc (1989) 716
F Supp 1504.
108 ibid s 155(2). The net assets are measured according to their book value at the time of the financial
assistance. A loan to, or a guarantee on behalf of, an acquiror will only deplete the target's net assets
where the acquiror is of doubtful solvency (see Hill v Mullis & Peake [1999] BCC 325, 331-333).
109 Companies Act 1985, ss 155(6) 156.
110 ibid s 121.
370 ( The Modem Law Review Limited 2000

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investment decisions. In some, share capital ranks as a

in others, it does not feature at all."2 Furthermore, the
to the CLRSG's Strategic Framework document sta
company's share capital is now relatively unimportant
repay credit.113 These findings are readily explicable. S
of value contributed to a firm by its shareholders at some
that value has been put into the firm, it may well have
information they generate seems to be of little use to
unlikely to be justifiable as a 'stand-alone' response to i
corporate credit markets.
Minimum capital and 'creditors' who do not co

We hypothesised that the policy goal of the minimum
protect 'creditors' who are unable to contract. If so, th
by the current law. First, the rules apply only to publi
evidence that these are more likely to have involuntar
companies. Second, the rules do not go so far as to cre
maintenance regime. Although the capital maintenance
to shareholders, there is no guarantee that assets will
trading losses. 15 Yet before dismissing the idea altoget
whether there is a case for strengthening the law so as
better. It is certainly possible to point to other Europ
offer more vigorous minimum capital regimes. For exa
Swedish company fall below half its share capital, t
either inject fresh equity to restore the net asset level, or
Whilst a stronger minimum capital regime - eg a univ
with the current capital maintenance rules, or ev
maintenance system - might reduce the extent to wh
used for judgment proofing against involuntary credi
haphazard. The amount necessary to intemalise the ris
depend on the activity in question. A universal minim
to achieve an appropriate level of deterrence in ma
judgment proofing would go up, but the practice
Furthermore, little of any minimum share capital is ev
involuntary claimants. Such parties generally rank
winding-up, and share with consensually unsecured cred
company's liquidation value after secured and prefe
111 J.F.S. Day, 'The Use of Annual Reports by UK Investment A

Business Research 295.
112 A.J. Berry et al, 'Financial Information, the Banker and the Small Business' (1993) 25 Brit
Accounting Review 131; D. Deakins and G. Hussain, 'Financial Information, the Banker and t
Small Business: A Comment' (1994) 26 British Accounting Review 323.
113 n 6 above, 23-24.
114 Cheffins, n 4 above, 532.
115 Companies Act 1985, s 142 requires a general meeting be called to decide what should be done
public company loses more than half its called-up share capital. However, there is no obligation
anything to be done, and the decision is given to shareholders, whose interests are likely to conflic
with those of creditors (D.D. Prentice, 'Corporate Personality, Limited Liability and the Protection
Creditors' in Grantham and Ricketts, n 48 above, 99, 103).
116 C. Norberg, 'Undercapitalized or Insolvent Companies in Company Law - Conflicts of Interest
Protection of Shareholders and Creditors' mimeo, Lund University (November 1998).
117 Prentice, n 115 above, 102.

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paid. Typically this will be very lit

Such a regime would also generate
cost of 'policing' firms' complian
burden for smaller companies. Se
minimum would be unable to obt
suggest that this would put such f
barriers to entry and thus reducing t
We might question how significan
benefits claimed for limited liabili
prices to be independent of the
information about the value of
shareholders, reducing the cost of r
a rational strategy, allowing for sp
functions - are likely to be at their
shares of such companies are not li
often the same people.122 Furthe
unlimited liability anyway, through
banks.123
Both the benefits from deterred judgment proofing, and the costs through denial
of limited liability, would seem to be increasing functions of the threshold at which
the 'minimum' is set. If a minimum capital regime were the only possible means of
internalising the costs of hazardous business activity, the debate would not be
closed until further empirical data became available. However, superior
alternatives exist. One is to regulate hazardous activity and to require that firms
carry insurance commensurate with their potential risk. The pricing of insurance
premia would be a more precise internalisation mechanism than a 'fixed-rate'
minimum capital requirement. Furthermore, the Third Parties (Rights Against
Insurers) Act 1930 transfers liability insurance claims against an insurer of an
insolvent firm from the firm to the party to whom it has incurred the liability,
ensuring that tort victims need not share their recoveries with the debtor's contract
creditors. Other techniques include granting involuntary claimants priority over
other claimants in corporate insolvencies,124 or imposing pro rata unlimited
liability on shareholders for corporate torts.125 These would cause voluntary
creditors or shareholders respectively to increase the firm's cost of finance in
proportion to the level of hazardous activity in which it is engaged. Even a rough-
and-ready mechanism such as a judicial doctrine of 'piercing the corporate veil' in
cases of 'unreasonably low' capitalisation would be likely to be cheaper in terms of
administrative costs than a general minimum capital requirement.126
118 eg Society of Practitioners of Insolvency, Company Insolvency in the United Kingdom: 8th SPI
Survey (London: SPI, 1999) 17 Fig 33 (12.6 per cent of face value).
119 n 42 above, 60-61.
120 ibid 41-44.
121 eg Halpern et al, n 48 above, 148. See also J. Armour, 'Corporate Personality and Assumpti
Responsibility' [1999] LMCLQ 246, 252-253.
122 See A. Cosh and A. Hughes, 'Size, Age, Growth, Business Leadership and Business Objectives
Cosh and A. Hughes (eds), Enterprise Britain: Growth, Innovation and Public Policy in the Small
Medium Sized Enterprise Sector 1994-1997 (Cambridge: ESRC Centre for Business Research,
3, 10.
123 J. Freedman and M. Godwin, 'Incorporating the Micro Business: Perceptions and Misperceptions' in
A. Hughes and D.J. Storey, Finance and the Small Firm (London: Routledge, 1994) 232, 246.
124 eg Leebron, n 48 above.
125 Hansmann and Kraakman, n 48 above.
126 eg n 42 above, 59.

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Capital maintenance, financial assistance and l

In the previous section, we noted that the maintenance o
rules prohibiting financial assistance impose restriction
might harm creditors' interests. However, restrictions of
might alternatively be generated through loan covenants.
legislation are not the costs which the prohibited transa
creditors, but rather the savings in contracting costs w
incurred. We need now to ask: how great are these saving
are the costs of having such restrictions framed as gene
Consider first capital maintenance. Several commentator
legal provisions are unlikely to be terms which any c
themselves.127 Share capital is based on historic valu
transferred to the firm, and as time goes on, it will becom
as a 'minimum financial condition' on which to base conditional distribution
restrictions. It is suggested that instead, tests which restrict shareholder asse
transfers on the basis of gearing (ratio of debt to equity) or liquidity (ability
realise cash for assets) would be more appropriate. If this is the case, then
'savings' in terms of drafting costs will be non-existent.
The strength of this conjecture may be tested through examining actual loa
contracting practices. The available empirical evidence suggests that loan
covenants used in UK lending agreements typically take the form of gearing
other financial ratios, but rarely restrict distributions to shareholders on the basis o
capital and/or profits.128 This in itself is not conclusive, because the evidence
equally consistent with the hypothesis that parties do not write such covenants
loan agreements because of the general law restrictions.
It is interesting therefore to note that in the US, where capital maintenanc
regimes are - depending on the state - either vestigial or extinct,129 conditio
restrictions on distributions to shareholders based on retained profits are repor
to be amongst the most common form of covenant. 130 What is more, Kalay's st
found that bond issues almost universally made use of a dividend restriction
similar form to the American Bar Foundation's indenture 'boilerplate',131 whic
in several respects analogous to section 263 of the Companies Act 1985.132
boilerplate restricts the firm's ability to engage in dividend payments, sh
127 J.R. Grinyer and I.W. Symon, 'Maintenance of Capital Intact: An Unnecessary Abstraction?' (1
10 Accounting & Business Research 403, 408; D.A. Egginton, 'Distributable Profit and the Pursu
Prudence' (1980) 11 Accounting & Business Research 3, 14; Manning, n 4 above, 33-34; Cheffins
4 above, 531-532.
128 See D. Citron, 'Accounting Measurement Rules in UK Bank Loan Contracts' (1992) 23 Accountin
Business Research 21, 23-24; Day and Taylor, n 37 above, 397-398; Day and Taylor, n 40 abo
321.
129 The doctrine was expunged from the post-1979 version of the Model Business Corporations A
(MBCA) and its successor the Revised MBCA (Manning, n 4 above, 164-180). The pre-1979 MBC
whilst formally restricting dividends, allowed for: (i) payments out of share premium; and (
reductions of capital by shareholder resolution (Manning, n 4 above, 59-76; J.D. Cox et a
Corporations (Guttersburg, NY: Aspen Law and Business, 1995, supp 1999) ? 21.16.
130 eg A. Kalay, 'Stockholder-Bondholder Conflict and Dividend Constraints' (1982) 10 Journa
Financial Economics 211, 214-216 (100 per cent of sample); Duke and Hunt, n 37 above, 55-56 (5
per cent of sample); Press and Weintrop, n 37 above, 74 (61 per cent of sample); cf M. McDani
106 above, 424-426 (35 per cent of sample).
131 Kalay, ibid, 216, footnote 9.
132 See American Bar Foundation, Commentaries on Debentures 410-411, in M.A. Eisenberg
Corporations and Business Associations: Statutes, Rules, Materials and Forms, 1995 ed (Westb
NY: Foundation Press, 1995) 782-786.

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repurchases and other gratuitous t

may be paid is based on net retaine
studies also found that gearing and
US lending agreements. One interpr
regime does in fact save UK lenders
Several factors suggest that this
even if we assume that US contrac
institutional factors.134 First, the
cumulative net profits since the bo
been incorporated. A creditor lend
distributable profits will in contrast
even if it loses money subsequent t
loan covenants presumably fact
decisions. If the capital mainten
one would therefore expect to find
ie enquire as to the size of the d
evidence suggests that UK creditor
Thus, whilst there may be pote
through the use of a 'collective te
how much, if any, are captured by
also generates costs. Where firm
impossible for capital to be return
reduction of capital procedure. The impact of these costs will be felt
disproportionately by small firms, and this may provide a deterrent to the
contribution of equity finance to such businesses.136
Turning to the financial assistance provisions, is a restriction on LBO activity
of the sort they imply likely to be efficient? This question is made harder to
answer because of the somewhat schizophrenic way in which the law is
structured.'37 First consider the position under an outright ban (ie if the
'whitewash' exception did not exist). This would greatly curtail LBO activity, as
appears to have been the case prior to the Companies Act 1981.138 Whilst LBOs
do have the capacity to harm the interests of creditors, it seems that most such
transactions are not motivated by 'asset stripping'. A number of empirical
studies suggest that, in general, losses to 'old' creditors consequent on LBOs are
small compared to gains in operating performance experienced by the
restructured company.139 These gains are thought principally to come from a
reduction in managerial agency costs, through the high-powered incentives
which share ownership and high levels of debt give to managers.140 Evidence
from US lending agreements suggests that increased awareness of 'LBO risk'
has led to a growth in the use in of 'poison puts' which allow bondholders to
133 C. Leuz et al, 'An International Comparison of Accounting-Based Payout Restrictions in the United
States, United Kingdom and Germany' (1998) 28 Accounting & Business Research 111.
134 cf M. Klausner, 'Corporations, Corporate Law, and Networks of Contracts' (1995) 81 Va LR 757; M.
Kahan and M. Klausner, 'Standardization and Innovation In Corporate Contracting (or "The
Economics of Boilerplate")' (1997) 83 Va LR 713.
135 Notes 111-112 above.
136 n 123 above, 259.
138 I. Webb, Management Buy-Out (Aldershot: Gower, 1985) 11-13.
139 See Wright et al, n 103 above, 158-161, and sources cited therein.
140 eg M.C. Jensen, 'Agency Costs of Free Cash Flow, Corporate Finance and Takeovers' (198
American Economic Review (Papers and Proceedings) 323, 325-326.

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accelerate their claims should a change in control occ

expropriatory transactions, but allow efficient ones
shareholder gains are greater than the creditor losses, t
pay the latter off. Thus even for public companies, an o
assistance seems unnecessarily restrictive: it would a
shares, regardless of whether a change in control is inv
whether the transaction is efficient.
Consider now a less restrictive bar of the sort implied by the 'whitewash'
regime. As we have seen, the possibility of a bought-out company being switched
from public to private means that realistically, this embodies the protection offered
to creditors of public as well as private companies against LBO risk. Terms dealing
with 'LBO risk' are not standard in UK lending agreements.142 This might suggest
that the statutory provisions save parties from having to contract for similar
protection. Once again, there are reasons for doubting this interpretation. First,
there are several differences between the loan covenants which US parties write to
cover this risk and the 'protection' offered under the whitewash regime. The legal
rules are broader - applying to all acquisitions of shares, rather than just changes in
control. Thus they catch many transactions which do not harm creditors. Yet where
a change of control does take place, they are less intensive in their protection than a
'poison put'. Second, Lehn and Poulsen find that in the US, 'poison put' terms tend
only to be adopted in lending agreements where debtors are perceived to be
takeover targets - about 30 per cent of their random sample.143 That they are not
standard in the UK is consistent with a similar pattern. The fact that the savings in
contracting costs are limited at best should be set against the opportunity costs
which the provisions surely create through inhibiting transactions - particularly in
small firms where the 'LBO risk' is marginal.
'Creditor terms' as default rules?
We have investigated whether the financial assistance and capital maintenanc

rules might act as loan covenants supplied by company law, thus saving parties the
costs of writing such terms themselves. A recurrent problem is that the 'terms'
supplied come in one form only, and apply mandatorily. An issue which seems
worth exploring is whether terms like these could not be supplied instead as
'defaults', allowing parties to contract out if they wish and thereby reducing th
costs of poor 'fit'.144
Default terms might be supplied into a creditor's contract with the company,
with the normal accompanying remedies. We might refer to these as 'individual
terms', because they would form part of each creditor's separate contract. A
creditors contract in parallel, it would be very costly for firms to contract out of
such default rules: all the creditors would need to agree. A default term supplied
into individual creditor contracts would therefore seem to be similar in effect to a
mandatory rule.145 An alternative proposal might run as follows: recall that a
significant role for company law vis-&-vis creditors was seen to be the supply of
mechanisms for collectivising creditors' rights when a corporate debtor becomes
141 Lehn and Poulsen, n 106 above, 671. See also Kahan and Klausner, n 134 above, 740-743
142 P.R. Wood, International Loans, Bonds and Securities Regulation (London: Sweet & Maxwell, 1995)
51; Day and Taylor, n 40 above, 323.
143 n 106 above, 658-659, 671.
145 See LCCP 153, SLCDP 105, n 8 above, 36.

155.93.147.231 on Mon, 08 Jul 2024 13:53:21 +00:00
insolvent.146 It may be that a role

rules as collective, rather than indi
by a solvent debtor. These would n
rather by an agent or a group of c
As we have seen, the capital main
'collective term'. A breach of th
direct rights of action against the
on behalf of creditors should the
assistance provisions are another e
state through the criminal law, an
Such collective terms could be m
whether or not to include them in
the outset, or to give firms some c
them subsequently.149 Provided t
company what sort of restrictions
have appropriate incentives to deci
What would be the appropriat
collective terms? Easterbrook and
should be chosen according to wha
had they been able to contract at
economies of scale in specificati
questioned whether such 'majorita
efficiency.152 One of the most
observation that creditors are hete
differ both within firms - having di
schedules - and between firms - r
and size. The implication is that b
unlikely to have significant econo
terms. 153
However, not all defaults need be structured on an 'opt out' basis, nor need a
sole default rule serve for all circumstances.154 An alternative approach would be
for the state to supply an opt-in 'menu' of covenants,155 from which firms could
146 Text to notes 43-47, above.

147 Possible mechanisms include: (i) ex post enforcement by a liquidator; (ii) the creation of a
representative committee of creditors which will have power to enforce and renegotiate rights on their
behalf (see Y. Amihud et al, 'A New Corporate Governance Structure for Bonds' (1999) 51 Stan LR
447); and (iii) enforcement by a state regulatory body.
148 Mills v Northern Rly of Buenos Ayres (1870) 5 Ch App 621. See N. Furey, 'The Protection of
Creditors' Interests in Company Law' in D. Feldman and F. Meisel (eds), Corporate and Commercial
Law: Modern Developments (London: LLP, 1996) 173, 176-179.
149 The reduction of capital procedure provides a mechanism for adjusting the constraints imposed by the
maintenance of capital doctrine, but does not allow firms to opt out altogether. The only way a (private)
company may currently opt out of restrictions on the withdrawal of share capital is by not raising it in any
significant quantity. This may distort firms' financing decisions (text to n 136, above).
150 See n 42 above, 17.
151 ibid 15.
152 A term coined by Ayres and Gertner, n 41 above, 93.
153 H. Kanda, 'Debtholders and Equityholders' (1992) 21 J Leg Stud 431, 440, Kahan, n 38 above, 60
610. See also Schwartz, 'Incomplete Contracts', n 29 above, 279; M.J. Whincop, 'Painting t
Corporate Cathedral: The Protection of Entitlements in Corporate Law' (1999) 19 OJLS 19, 28-2
154 Ayres and Gertner, n 41 above, 93-95; Cheffins, n 4 above, 217-218.
155 Klausner, n 134 above, 839-841. See also (in the context of corporate insolvency procedures) R
Rasmussen, 'Debtor's Choice: A Menu Approach to Corporate Bankruptcy' (1992) 71 Tex LR 51;
Schwartz, 'A Contract Theory Approach to Bankruptcy' (1998) 107 Yale LJ 1807.

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then select provisions to become 'collective terms' in t

might imagine that some firms would want to offer cre
like restrictions. Others would wish to avoid this, leav
market contracting.
It might be argued that even a range of default term
cater for the widely divergent needs of different parti
the heterogeneity point. Within firms, creditors contra
debtor's freedom of action will be determined by the st
between firms, the evidence on loan contracting pract
reasonably well-defined types of term are used by a wid
Another possible objection is the fear that firms
restrictions, thus leaving creditors with less protect
moment. However, the evidence on loan contracting sug
spend money writing and negotiating complex covenant
If the same result can be achieved more cheaply throu
there are obvious incentives to opt in. Nor would th
creditors would be made worse by such a step. The
financial assistance regimes do nothing to protect such
a commitment to a minimum capital regime - itself, as
regulatory strategy.157
Conclusions
The current law relating to share capital can be rationalised as an attempt to pr

corporate creditors from expropriation by shareholders. Whilst in theory, r
which prevent such wealth transfers can enhance efficiency, the argum
involved do not justify regulation in the form of the current provisions. The
imposes haphazard restrictions on companies which are ill-tuned to the needs
parties. On the whole, the costs of such restrictions are likely to outweigh a
benefits they bring.
Whilst a case may be made for legal intervention to prevent shareholders fr
using limited liability companies to 'judgment proof' themselves when engagin
hazardous activities, the sporadic approach of the current minimum capital re
seems inadequate to do so. A case may be made for strengthening the regime
application, but there are a variety of alternative mechanisms which could be
to achieve the same policy goal more cheaply and effectively.
The information which is disclosed and 'verified' by the rules which regulat
raising of share capital seems to be of little, if any, relevance to creditors in m
lending decisions. Attempts to justify these provisions as a means of minimi
information asymmetry problems in corporate credit markets are there
unpersuasive. It is possible to view the capital maintenance doctrine and fina
assistance prohibitions as attempts to save contracting costs through the prov
of 'collective loan covenants'. Whilst the empirical evidence on loan coven
shows that there are potential savings in contracting costs to be had, it is uncle
what extent - if at all - these are captured by the current law. Furthermore, be
the 'terms' supplied are mandatory and general in their application, firms for w
they are not suited must incur the opportunity costs of transactions frustrated by
156 Notes 37, 40 above.

157 Text to notes 124-125, above.

155.93.147.231 on Mon, 08 Jul 2024 13:53:21 +00:00
restrictions. However, if companie

variety of such 'collective term
contracting costs to be captured, w
transactions. Establishing the re
important question for future resea
This article offers a tentative vali
suggests that the use of an efficien
insights into some, at least, of the
company law. The CLRSG's preli
largely of an incremental nature
requirement that the court approv
declaration of solvency by directors
public companies are of course
Directive.160 The CLRSG's propos
amplified in a fifth consultation do
take the view that the financial as
private companies, and propose t
document also considers whethe
requirement - or even a 'solvency
should be introduced.163 This are
minimum capital provides no prote
solvency margin is 'disproportiona
article provides support for this rea
are likely to enhance the efficiency
158 See n 6 above, 22-54.

159 ibid 34-35. Creditors of public companies would, however, retain a right to obect to the court.
160 The Strategic Framework, n 5 above, 21-23. However, the Directive is due to be simplified in line
with recommendations from Phase IV of the Simpler Legislation for the Internal Market (SLIM)
Initiative. These include the relaxation of the financial assistance ban and the 'expert valuation' rules
(E. Wymeersch, 'Company Law in the 21st Century'. Universiteit Gent Financial Law Institute
Working Paper 1999-14, 4; Single Market News No 19, December 1999).
161 Modern Company Law for a Competitive Economy: Developing the Framework (London: DTI, 2000).
162 ibid 232-234.
163 ibid 306.

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Share Capital and Creditor Protection: Efficient Rules for a Modern Company Law

Author(s): John Armour

Stable URL: https://www.jstor.org/stable/1097174

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A number of provisions of the Companies Act 1985 regulate dealings with

1 Companies Act 1985, Parts IV, V and VIII.

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Economic analysis offers a way o

The goals of a modern company law

356 0 The Modem Law Review Limited 2000

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reforms. The first principle seems to be the most funda

It would seem that an analysis of the (dys)functioning o

C The Modem Law Review Limited 2000 357

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intervention as the remedy. Such a cr

How might law assist in facilitating transactions with corporate

358 ( The Modem Law Review Limited 2000

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Precontractual information asymmetries

Incomplete contracts and postcontractual opp

24 G. Akerlof, 'The Market for Lemons: Quality Uncertainty and

C The Modem Law Review Limited 2000 359

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circumstances relevant to his perf

360 C The Modern Law Review Limited 2000

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It is therefore rational for parties to spend mon

34 Jensen and Meckling, n 30 above, 334-343.

? The Modem Law Review Limited 2000 361

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do not find themselves saddled wit

Collective action problems a

'Creditors' who do not contract

A rather different set of issues is raised by so-called 'involuntary' creditors

362 C The Modem Law Review Limited 2000

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Agency and the Inland Revenue, are not. The idea i

How does the law relating to share capital protect creditors?

We now turn to an examination of the rules which restrict dealings in corporate

49 eg J.-J. Laffont, 'Externalities' in Eatwell et al (eds), n 24 above, 112.

C The Modem Law Review Limited 2000 363

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provisions derived from the Secon

364 C The Modem Law Review Limited 2000

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C The Modern Law Review Limited 2000 365

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share of capital and surplus, insofar

73 see Re Northern Engineering Ltd [1994]

366 c The Modem Law Review Limited 2000

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company providing the court with evidence of a bank guara

This envisages protecting creditors from the risk that

84 The statute prescribes a lengthy procedure whereby creditors must be

C The Modem Law Review Limited 2000 367

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make payments to themselves. The

368 C The Modern Law Review Limited 2000